The 1%

January 6, 2014

“The 1%” phrase has been used a lot to decry income inequality, but I’m using it here in an entirely different context.  I’m thinking about the 1% in relation to a recent article by Motley Fool’s Morgan Housel.  Here’s an excerpt from his article:

Building wealth over a lifetime doesn’t require a lifetime of superior skill. It requires pretty mediocre skills — basic arithmetic and a grasp of investing fundamentals — practiced consistently throughout your entire lifetime, especially during times of mania and panic.  Most of what matters as a long-term investor is how you behave during the 1% of the time everyone else is losing their cool.

That puts a little different spin on it.  Maybe your behavior during 1% of the time is how you get to be part of the 1%.  (The bold in Mr. Housel’s quotation above is mine.)

In his article, Housel demonstrates how consistency—in this case, dollar-cost averaging—beats a couple of risk avoiders who try to miss recessions.  We’ve harped on having some kind of systematic investment process here, so consistency is certainly a big part of success.

But also consider what might happen if you can capitalize on those periods of panic and add to your holdings.  Imagine that kind of program practiced consistently over a lifetime!  Warren Buffett’s article in the New York Times, “Buy American.  I Am.” from October 2008 comes to mind.  Here is a brief excerpt of Mr. Buffett’s thinking during the financial crisis:

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So … I’ve been buying American stocks.

If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Gee, I wonder how that worked out for him?  It’s no mystery why Warren Buffett has $60 billion—he is as skilled a psychological arbitrageur as there is and he has been at it for a very long time.

As Mr. Housel points out, even with mediocre investing skills, just consistency can go a long way toward building wealth—and the ability to be greedy when others are fearful has the potential to compound success.

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DWA Technical Leaders Index Trade Profiles

January 6, 2014

The Dorsey, Wright Technical Leaders Index is composed of a basket of 100 mid and large cap securities that have strong relative strength (momentum) characteristics.  Each quarter we reconstitute the index by selling stocks that have underperformed and by adding new securities that score better in our ranking system.  We began calculating the index in real-time at the end of 2006.  Over the last seven years there have been quite a few deletions and additions as the index has adapted to some very dynamic market conditions.

Any relative strength or momentum-based investment strategy is a trend following strategy.  Trend following has worked for many years in financial markets (although not every year).  These systems are characterized by a several common attributes: 1) Losing trades are cut quickly and winners are allowed to run, 2) there are generally a lot of small losing trades, and 3) all of the money is made by the large outliers on the upside.  When we look at the underlying trades inside of the index over the years we find exactly that pattern of results.  There is a lot going on behind the scenes at each rebalance that is designed to eliminate losing positions quickly and maintain large allocations to the true winners that drive the returns.

We pulled constituent level data for the DWATL Index going back to the 12/31/2006 rebalance.  For each security we calculated the return relative to the S&P 500 and how many consecutive quarters it was held in the index.  (Note: stocks can be added, removed, and re-added to the index so any individual stock might have several entries in our data.)  The table below shows summary statistics for all the trades inside of the index over the last seven years:

 

The data shows our underlying strategy is doing exactly what a trend following system is designed to accomplish.  Stocks that aren’t held very long (1 to 2 quarters), on average, are underperforming trades.  But when we are able to find a security that can be held for several quarters, those trades are outperformers on average.  The whole goal of a relative strength process is to ruthlessly cut out losing positions and to replace them with positions that have better ranks.  Any investor makes tons of mistakes, but the system we use to reconstitute the DWATL Index is very good at identifying our mistakes and taking care of them.  At the same time, the process is also good at identifying winning positions and allowing them to remain in the index.

Here is the same data from the table shown graphically:

 

You can easily see the upward tilt to the data showing how relative performance on a trade-level basis improves with the time held in the index.  For the last seven years, each additional consecutive quarter we have been able to keep a security in the Index has led to an average relative performance improvement of about 920 basis points.  That should give you a pretty good idea about what drives the returns: the big multi-year winners.

We often speak to the overall performance of the Index, but we sometimes forget what is going on behind the scenes to generate that return.  The process that is used to constitute the index has all of the characteristics of a trend following system.  Underperforming positions are quickly removed and the big winning trades are allowed to remain in the index as long as they continue to outperform.  It’s a lot like fishing: you just keep throwing the small ones back until you catch a large one.  Sometimes it takes a couple of tries to get a keeper, but if you got a big fish on the first try all the time it would be called “catching” not “fishing.”  I believe part of what has made this index so successful over the years is there is zero human bias that enters the reconstitution process.  When a security needs to go, it goes.  If it starts to perform well again, it comes back.  It has no good or bad memories.  There are just numbers.

The performance numbers are pure price return, not inclusive of fees, dividends, or other expenses.  Past performance is no guarantee of future returns.  Potential for profit is accompanied by potential for loss.  A list of all holdings for the trailing 12 months is available upon request.

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Weekly RS Recap

January 6, 2014

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and quartile and then compared to the universe return.  Those at the top of the ranks are those stocks which have the best intermediate-term relative strength.  Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (12/30/13 –1/3/14) is as follows:

ranks 01.06.14

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Investor Behavior

January 6, 2014

Marshall Jaffe, in a recent article for ThinkAdvisor, made an outstanding observation:

In a world where almost nothing can be predicted with any accuracy, investor behavior is one of the rare exceptions. You can take it to the bank that investors will continue to be driven by impatience, social conformity, conventional wisdom, fear, greed and a confusion of volatility with risk. By standing apart and being driven solely by the facts, the value investor can take advantage of the opportunities caused by those behaviors—and be in the optimal position to create and preserve wealth.

His article was focused on value investing, but I think it is equally applicable to relative strength investing.  In fact, maybe even more so, as value investors often differ about what they consider a good value, while relative strength is just a mathematical calculation with little room for interpretation.

Mr. Jaffe’s main point—that investors are driven by all sorts of irrational and incorrect cognitive forces—is quite valid.  Dozens of studies point it out and there is a shocking lack of studies (i.e., none!) that show the average investor to be a patient, independent thinker devoid of fear and greed.

What’s the best way to take advantage of this observation about investor behavior?  I think salvation may lie in using a systematic investment process.  If you start with an investment methodology likely to outperform over time, like relative strength or value, and construct a rules-based systematic process to follow for entry and exit, you’ve got a decent chance to avoid some of the cognitive errors that will assail everyone else.

Of course, you will construct your rules during a period of calm and contemplation—but that’s never when rules are difficult to apply!  The real test is sticking to your rules during the periods of fear and greed that occur routinely in financial markets.  Devising the rules may be relatively simple, but following them in trying circumstances never is!  As with most things, the harder it is to do, the bigger the potential payoff usually is.

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